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The Property Cycle – Where are we now?

Prices rising in Perth and dropping in Sydney, interest rates rising and affordability dropping - is it all bad news, or just another phase in the property cycle? We take a look at how and why home prices have repeatedly gone through peaks and troughs, rising to seemingly impossible heights over the years before dropping yet again.

Historically, property cycles in Australia have lasted around seven years, from peak to slowing down to a flat period then back to a peak. The late 80s, for instance, saw a major boom in values in Sydney where prices literally doubled over a two and a half year period followed by a slump in 1990-1991. The next period was uncharacteristically long, culminating in a peak around 2003.

Yet a closer glance at historical figures shows that the market has never really ‘crashed’, and that house values have consistently risen by about 10 per cent per annum over the past forty years.

Interestingly enough, the level of home ownership in Sydney and across Australia has remained consistent at around 70 per cent, despite the cycles and despite booms and recessions.

That 70 per cent home ownership provides a built in safety net for the residential property market. Owner-occupiers (people who own their own homes) do not panic and rush to sell as investors do in some other sectors such as industrial and commercial real estate, or company shareholders, when times get tough. Everybody must be housed, whether they rent, or are owner-occupiers.

So what is it that makes a market rise at certain times and fall at others?

During a period of strongly rising values, a number of things happen, but mainly the rate of construction of new property increases.

This is because developers and speculators are constantly monitoring the investment equation. They look at land costs,calculating that if they buy land for $X, expend $Y on construction and other costs and they sell for $Z on completion, the difference is the profit margin. When values are rising strongly, there is greater potential return, so more will commit todevelopment and therefore the rate of construction increases dramatically.

Nobody tells builders, developers or speculators when to stop. They keep building as values are rising, to take advantage of the strong market. Then, at some point in time, there will be more dwellings built and placed on the total market than there are people to occupy them.

How can values rise any further when there is a surplus of property and not enough buyers in the market to buy or rent them? Accordingly the market will stall. Values tend to simply level off, and with inflation at work, real values will fall.

So the developers and speculators withdraw from the market and the rate of new construction declines over time.

However, the population continues to increase, and as children leave home they enter the market in their own right. After a while, the excess property is slowly absorbed.

And so the pendulum of supply and demand tilts again.

The first sign of this change is in the rental market. The vacancy rate - that is, the proportion of vacant rental properties in the market - will fall and as a result rents will rise. With rising rents, investors are normally the first to be attracted back into the market.

As investors re-enter the market after a downturn, prices will start to push up again slowly. Home buyers see values rising and want to ‘get in on the ground floor’ of the next boom or, in the case of the first home buyer, before prices go beyond their reach.

The supply demand equation

The supply and demand see-saw will go on forever. But in property terms, what constitutes supply and demand?

Supply of property in a residential market means the total stock of dwellings that exist in that market. Demand in a property market relates to the number of households which require a roof over their heads, and how that may change over time.

Brett Johnson, CEO of investment advisory group Quartile Property Network, says these forces of supply and demand have always been, and will always be, the engine that drives residential prices.

“All things being equal, if demand exceeds supply, prices will rise. If supply exceeds demand, prices will fall, or remain the same. If demand equals supply, nothing much will change”, says Mr Johnson.

So let’s look at what contributes to the demand for housing. Firstly, there is the current number of households and how the dynamics of those households are changing. There has been an explosion of single person households due to people living longer and high divorce rates, while the number of older children living with parents longer than in the past, marrying later and having children later has increased dramatically. Then there are the more ‘natural’ factors such as the birth rate, immigration, interstate migration and changes in employment locations.

The influence of interstate migration and employment on the marketplace has been dramatically evidenced by the boom in the Northern Territory and Western Australia in the last 18 months. Strong economies in those states, underpinned by a resources boom have resulted in high demand and restricted supply has seen house prices skyrocket by over 24 per cent in the last 12 months.

Johnson suggests that where there is an under-supply, the natural conclusion can only be that given reasonable economic conditions, the growth engine is fuelled up and prices will rise.

“Equally, if the market is oversupplied, even in strong economic conditions, the tank is empty and growth other than perhaps keeping up with inflation will not happen”, he added.

The forces of supply and demand are the main ingredients in fuelling prices. This is why the market is cyclical, at times, rising strongly.

What triggers the peaks and the troughs?

For the homeowner, the most obvious factor is interest rates. When interest rates rise, or even with the mere speculation that they may, buyers begin to be a little more cautious again. Mortgage repayments become more difficult for some owners, which in turn leads to homes being put back on the market, often at lower prices.

ANZ Senior Economist Ange Montalti says that since the 1970s every housing market upturn has been associated with some coincident or leading downward adjustment to interest rates.

“We have to go back to the mid-1950s to 1970 period to evidence two housing upturns that were not triggered by interest rate falls”, said Mr Montalti.

What was driving those early cycles was strong population growth and underlying demand. Building activity was responding to the need to house a growing population. Montalti believes that similar fundamentals are with us today and the market is not going to wait for interest rate falls to begin rectifying the demand/supply imbalance.

Other economic factors can help turn the market one way or another. The introduction of the GST in 2000 triggered a rush of both purchasing and construction activity as people attempted to buy or build their homes before GST took effect. Likewise, land taxes, tax cuts and grants such as the First Home Owner Grants have all affected buyer activity.

Just where are we now?

Figures over the past few years have shown that the markets in most states have experienced a slight downturn, with the obvious exception of Western Australia and the Northern Territory.

The June quarter 2006 figures from the Real Estate Institute of Australia (REIA) indicate a booming market in WA and the NT, with prices up 33.9 per cent and 25.1 per cent respectively.

REIA President Tony Brasier says that Perth now has the second most expensive house price in Australia.

“This is largely in response to the resources boom, increased employment and migration with no immediate end in sight. Perth particularly might have more growth to come in the short term”, Mr Brasier said.

“This is putting considerable pressure on rental markets, and vacancy rates are continuing to decline around the country, ranging from a June quarter 2006 low of 1.6 per cent in Adelaide to 2.4 per cent in Darwin. Median rent increases over the year to June 2006 have outpaced the four per cent annual CPI increase in many areas”, he said.

What is the next phase in the cycle?

Analysts are predicting that the market will continue to bump along for a while, without major fluctuations up or down in prices, until it becomes more affordable. Many suggest that the Sydney market has already started to turn as investors take advantage of the shortage of rental properties and subsequent higher yields, which are expected to rise as much as 5-6 per
cent.

Tony Brasier concludes that while the news is not the best for first home buyers and renters, the current housing market offers good news for investors.

“Although the property market varies significantly across the country, one thing that remains constant is the ongoing excellent returns which can be achieved by long-term investors”, he said.

If the theory is right, this renewed confidence will spread around the nation, giving rise to another cycle beginning next year.